A government’s tax base is the lifeblood of any government.
While it is their job to collect tax revenue, we like to think it is our job to make sure you avoid over paying in taxes!
Generally speaking, the larger the tax base, the more earnings (both foreign and domestic) will be realized by the country’s citizens. This, in turn, means higher tax revenues for the country.
The topic of this article is the tax treatment of foreign source income.
Our goal is to shed light on the two ways that governments tax foreign income and the various strategies available to individual taxpayers who earn income abroad.
Worldwide Taxation: Taxes Levied Based On Citizenship
In the entire world, there are only two countries that adopt a worldwide system of taxation: the United States and Eritrea.
(In case you are wondering, Eritrea is a small Eastern African country with a population a little over six million people.)
A worldwide system of taxation levies taxes based on a taxpayer’s citizenship; making “offshore” income subject to the same treatment as domestically produced income.
For U.S. citizens (and those of Eritrea), it doesn’t matter where one resides or which country their income is derived from. Taxes on their worldwide income are to be paid.
The IRS couldn’t be any clearer about this:
“If you are a U.S. citizen or resident alien, the rules for filing income, estate, and gift tax returns and paying estimated tax are generally the same whether you are in the United States or abroad. Your worldwide income is subject to U.S. income tax, regardless of where you reside.” [Emphasis ours]
Here’s a hypothetical:
Suppose a U.S. citizen decides to start a company in Panama. She moves to Panama as an expatriate and her company begins to produce income according to her projections.
Despite the fact that she no longer lives in the U.S and that her business has no ties to the U.S. she is still required to pay taxes to the U.S. Government because she is a citizen of the United States.
Territorial Taxation: Taxes Levied Based On Geography
In contrast to the worldwide system of taxation, the territorial tax system, adopted by the rest of the world at large, makes no claim to income earned beyond the borders of the taxpayer’s domicile.
Taxes are strictly levied based on where the person resides and where the income is derived, allowing a citizen to produce income outside of her country without creating an income tax liability to her country of citizenship.
If the entrepreneur in the example above were Canadian, she would have zero tax liability to the Canadian government. Her income tax liability would be due to the Panamanian government.
Tax Inversions: How Burger King Effectively Changed Its “Citizenship”
The advantages of a territorial tax system have not only been a harbinger of corporate tax reform, but an impetus for the relocation of U.S. multi-national companies’ domicile since US corporations are subject to a worldwide tax system in the same way individuals are.
As Burger King (now Restaurant Brands) acquired Canada’s Tim Horton’s, a coffee and doughnut chain, the burger giant has effectively undergone a tax inversion by changing its corporate structure.
A tax inversion occurs when a domestic company merges with a foreign one, and in the process reincorporates abroad, effectively entering the foreign country’s tax domicile.
One of the key reasons said to inspire this “change of citizenship” by Burger King was the fact that Canadian corporate tax rates are more favorable relative to U.S. corporate tax rates.
Canada’s total corporate rate of 26.5% (Ontario) versus the U.S. corporate tax rate of 35% was enough for Burger King to change its domicile to Canada.
Americans For Tax Fairness (AFTF) estimates that Burger King will save at least $400 million from the move.
Solutions for Double Taxation
Barring the drastic course of renouncing one’s US citizenship and moving abroad through naturalization or various economic citizenship programs, U.S. taxpayers cannot legally skirt the reach of the worldwide tax system.
They can, however, ensure they aren’t taxed more than they should be, by taking advantage of existing provisions contained both in the tax code and various tax treaties.
Here are a couple of those solutions:
- Foreign Earned Income Exclusion – Allows a U.S. taxpayer living abroad to exclude all or part of their foreign income from being subject to U.S. income tax. Meals and lodging provided by an employer may also be excluded. For the year 2016, the amount of income that can be excluded is $101,300. U.S. taxpayers eligible for this exclusion should file Form 2555 or 2555-EZ along with Form 1040.
- Foreign Tax Credit – Another option is to take a foreign tax credit. The credit is allowed for taxes paid or accrued abroad on the income that is also taxable in U.S. Form 1116 is used by individuals who want to claim foreign tax credit and Form 1118 is used by corporations.
- Tax Treaties – Four ways they may help ease the tax burden:
- a. For U.S. residents, reduced rates or exemptions on specific types of U.S. income can be realized due to the tax treaties that the U.S. has with a number of foreign countries.
- b. Certain U.S. states tax the income of their residents. It is important to note that not all states honor the provisions of U.S. tax treaties. The best course of action for a taxpayer is to contact the state of residence to find out if the state taxes the income of individuals and whether the tax treaty applies.
- c. Because U.S. citizens and residents are subject to U.S. income tax on their worldwide income, tax treaties do not reduce taxes for citizens or residents. However, they do reduce the U.S. taxes of residents of foreign countries. U.S. citizens or residents may qualify for certain credits, deductions, exemptions, and reductions in the rate of taxes when receiving income from a treaty country.
- d. In order to prove a taxpayer is entitled to tax treaty benefits, foreign taxing authorities will sometimes require certain certification from the U.S. Government. This is to verify that an applicant filed an income tax return as a U.S. citizen or resident.